There are two separate issues that regulators must address. The first is to try to prevent financial collapses from happening at all, and the second is to try to minimize the effects of a collapse if it occurs despite our efforts to prevent it.
No matter what we do, I don't think we can ever guarantee that the financial system will be safe. There is always the danger that problems could suddenly occur. We should do our best to prevent collapse, of course, but we also need to insulate ourselves from damage if a meltdown occurs anyway. Since leverage ratios are a key factor determining the severity of a collapse -- the larger the ratio the more there is to unwind and the larger the downfall -- I believe we need strict limits on leverage ratios.
We should also limit bank size, but the main reason is not because it will help to prevent breakdowns of the financial system. Past experience shows that many small banks can fail just as easily as a few big banks and do every bit as much damage, so size alone does not appear to be the most important factor. But if the term size includes the notion of connectedness among banks, then I think that making banks smaller, i.e. less connected, is useful for both limiting the chance of a collapse, and for reducing the damage if a collapse occurs. So the connections between banks (and within large banks if they are allowed to exist) are an important factor for regulators to take into account.
There is, however, an important sense in which size is important. When financial institutions reach the scale of operation of the largest banks of today, they have substantial economic and political clout. That clout leads to what economists call "regulatory capture," a term that describes the way in which politically powerful firms can influence legislation and create a culture that allows them to escape regulatory oversight. Legislators and regulators end up serving in the firms interests, usually at the expense of the public.
The manner in which this increase in political and economic power within the financial industry happened in recent decades, and the consequences of this change, is another theme of the book. It's not healthy for the economy when individual firms have so much political and economic power -- it is far from the idealized competitive markets in textbooks that have such nice properties -- and I fully agree with the conclusion that the banks need to be scaled down.
I have not seen a convincing argument that there are substantial economies of scale from having banks so large, so there is no compelling reason for the existence of mega-banks. But there are good reasons for scaling them back. Unfortunately, one of the main worries from having banks that are so large, excessive political power, may make it difficult for legislators to reduce the scale of firms within the financial industry. But reducing the political and economic power these banks have is important, and people like Simon Johnson and James Kwak are right to keep pushing hard for legislators to operate in the public interest and put strict limits on bank size.
The problem here is the same problem that exists internationally, if one country passes a regulation but other countries don’t, business may simply move elsewhere. A country such as the US can retaliate some by simply refusing to allow financial transactions that don’t pass through particular regulated institutions, though even this is imperfect and can be evaded. For states, it’s even tougher since it’s hard to pass such laws disallowing commerce across state lines (the constitution…). So for limiting leverage, I think this has to come at the national level, states can’t do a whole lot to limit this on their own. States do have some power, there are both state and federal bank charters and states could insist that banks have higher capital ratios if they operate under a state charter, but this puts them at a disadvantage relative to other state and federal banks and they would likely look for ways to shift the money across state lines where it was no longer subject to restrictions (e.g. through branching).But that’s not to say that state regulators couldn’t have done a better job of identifying problems (though I think the big problems were at national banks) so that a policy calling for a review of state regulations and the performance of regulators might be useful (as would a call to beef up the regulatory agency budgets, though a call for more spending may not be popular…).This is all “off the cuff”, but hope it’s useful in some way.
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